There are significant outflows of deposits now in Spain and they won’t start coming back until people are sure they’re safe and that Spain is secure

Spanish banks, already hooked on cheap European Central Bank loans, are hemorrhaging deposits as the government debates whether to seek a bailout.

Households and companies drained 26-billion euros (US$34-billion) from Spanish bank accounts in July, driving the ratio of loans to deposits among lenders to 187% from 183% in December and 182% a year earlier, according to data compiled by the Bank of Spain. Shrinking deposits undermine the ability of banks to support economic growth by lending to companies and consumers.

“There are significant outflows of deposits now in Spain and they won’t start coming back until people are sure they’re safe and that Spain is secure,” said Simon Maughan, a financial strategist at Olivetree Securities Ltd. in London.

Spain’s financial industry is already backstopped by Europe to the tune of 100-billion euros, and is reliant on 412-billion euros of gross borrowings from the ECB. Investors demand 423 basis points more to own CaixaBank SA bonds maturing in 2015 than German bunds of similar maturity, up from a premium of about 384 when the bonds were sold in January.

Bond markets have reopened for Spanish banks after ECB President Mario Draghi pledged to help bring down government borrowing costs. Banco Santander SA led a return to wholesale debt markets last month when it sold 2-billion euros of senior unsecured bonds in the first sale by a Spanish bank in more than five months. Santander paid 390 basis points more than the benchmark swap rate, compared with a 250 basis-point premium on five-year bonds that the bank sold in March.

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Ratio Requirements

Governments must first seek wider help from Europe’s rescue mechanism before the ECB will buy bonds. Moreover, the terms of Portugal’s May 2011 bailout require its banks to achieve a loan- to-deposit ratio of 120% by the end of 2014, while Ireland’s deal demands a ratio of 122.5% by 2013. No such provision was included in the July memorandum of understanding for Spain’s bank bailout.

“The first consequence of a lower loan-to-deposit ratio being set is that you have to identify chunks of assets to sell and that inevitably leads to haircuts and capital implications,” said Eamonn Hughes, an analyst at Dublin-based Goodbody Securities. “It also forces you to pay up for deposits, as we have seen in the Irish case.”

Imposing a loan-to-deposit target for Spanish lenders may mean they would have to reduce lending by 14% to 24%, Daragh Quinn and Duncan Farr, analysts Nomura International, wrote in a report published Monday. “The need to strengthen customer funding could also see the emergence of a deposit war, putting additional pressure on revenues, which are already likely to suffer from the low interest rate environment,” they said.

Record Outflow

Scrutiny of customer fund outflows at Spanish banks has intensified since the ECB said Aug. 28 that so-called private sector deposits shrank by 74-billion euros, or 4.7%, in July, the biggest drop on record. The ECB data include items such as deposits by securitization funds that banks say they don’t rely on for financing their business.

Banco Bilbao Vizcaya Argentaria SA said in a Sept. 4 report that a decline in securitization funds deposits helped explain the drop as banks substituted them by issuing covered bonds to discount at the ECB. Household and company deposits are stable once the practice of banks using instruments such as commercial paper to raise funds is taken into account. The loans-to-deposit ratio for BBVA’s Spanish business is 167%, according to the bank’s own data.

Accelerated Decline

Figures from Spain’s banking association showed deposits for Santander’s Spanish business dropped 6.3% in July from June, while BBVA’s slumped 7.1%, said the association, known as AEB.

Santander said the decline in July was partly due to a drop in repurchase agreements. BBVA spokesman Paul Tobin also attributed the bank’s deposit slide to repos, saying the data cited by AEB was for its operations in Spain, Portugal and the wholesale business elsewhere in Europe and New York.

There is “a clear underlying trend of accelerating deposit decline,” Nomura’s Quinn wrote in a Sept. 4 report. Term deposits by households fell 6.9% in July from a year earlier, while those of companies fell 24%, which “points to continued deposit declines in the future,” he said.

About 86% of Bankinter SA’s estimated 2013 profits derive from its ability to borrow cheaply from the ECB, the analysts said, with Banco Popular Espanol SA dependent on central bank funds for about 79% of earnings. Meanwhile, Bank of Spain data shows lenders are offering higher deposit rates to attract cash, with interest rates on account for as long as one year climbing to 2.5% in July, the highest level since March.

Declining deposits may inflict more damage on the Spanish economy if the seepage of the most reliable source of funding further dries up credit, said Maughan at Olivetree. The International Monetary Fund predicts Spain’s economy will contract 1.7% this year and 1.2% in 2013.

“If deposits are falling, then the only option for Spanish banks to bring down their loans to deposit ratio is to cut back on the loans side,” Maughan said. “Does that sound like a good idea?”